Dec 23, 2019

How to Use Collateral to Secure a Business Loan

If you need a loan to kick-start your business growth, you have several options. But first, you need to decide whether you want to apply for a loan secured against collateral or an unsecured business loan.

Loans secured by collateral have a range of advantages: 

On the other hand, unsecured loans aren’t as paperwork-intensive but do have strict qualifying criteria. The main advantage is that your asset won’t be in jeopardy if you’re unable to keep up with your payments.

The process of applying for a secured loan can be daunting for someone who hasn’t done it before. Here are a few tips that can increase your chances of a successful application.

1. Find Out What You Can Use as Collateral

When you apply for financing, the lender’s first consideration is your ability to pay back the loan. Backing your loan with collateral helps them ensure repayment. 

Most traditional lenders have similar definitions regarding what constitutes collateral. There are the assets you own outright and the assets that still have loans against them. If you have a loan secured against your home, the lender will often want to refinance the debt.

The lender gains ownership of your collateral if you default on payment, so it’s important to understand your options. Here are some examples of collateral you can use to secure a loan:

Home Equity

Home equity is commonly the most valuable asset of an individual. Be warned, however, that you most likely will only be able to take out a small portion of the equity that you have accrued on your home because of the strict debt-to-income ratios most financiers follow.

401k

A 401k can be leveraged as loan collateral, but these contribution plans have potential tax consequences and major limitations. Most plans allow the contributor to take out a loan at a prime interest rate plus 1 or 2 points.

Commercial Properties

If you’re buying property, you can use that very property as collateral for a commercial loan. You can also borrow against commercial properties you already own to fund other projects. Banks usually lend up to 50% of the value of commercial property and require a minimum down payment between 15% and 35% of the overall purchase price.

Equipment

Equipment loans work in the same way that commercial loans do, but the loan is secured by the equipment. Should you default, the equipment becomes the lender’s property. 

Automobiles

You can use your vehicle as collateral if you own it outright or if the total amount owed is less than its value. Estimate the Kelly Blue Book value of your vehicle and compare it to your payoff amount. Check to see if your lender allows the use of vehicles as collateral before offering yours.

Accounts Receivable and Purchase Orders

Asset-based loans are a class of liabilities based on receivables and inventory that are used as collateral. Asset-based lenders will give you a small business loan backed by 100–125% of the value of your receivables.

Credit Card Transactions and Deposits

Small businesses can also use merchant cash advances, where a company trades a portion of its credit card sales for a lump sum loan. This type of payment has no personal guarantee—it applies to your company only, and it will not affect your personal credit score if you cannot repay the loan. This form of financing is very flexible, but be aware that the interest rates can be very high.

2. Determine How Much Collateral is Needed for a Business Loan

When it comes to how much collateral is necessary for a loan, the answer varies substantially depending on the details of the loan and the financial situation of the business seeking it. Sometimes the collateral needs to be worth an amount equal to that of the loan, while other times the collateral must be higher in value than the loan. And then there are times when collateral isn’t even required.

With a secured loan, the value of your collateral will usually be equal to the amount of the money you’re borrowing. The math is simple—if you can’t repay your $37,000 loan, the lender is going to want something from you worth $37,000.

In some cases, however, lenders want your collateral to be worth more than the loan amount because there are costs associated with selling an asset. If you used your cabin as collateral then defaulted on the loan, the lender would need to hire a real estate agent and would only get repaid once the cabin finally sold.

Some lenders offer unsecured financing that doesn’t require collateral. Unsecured loans are usually much smaller than secured loans, with higher interest rates and less user-friendly repayment terms. And they don’t completely insulate you in the case of a default. Many lenders will still require a personal guarantee, making you personally responsible if your business can’t repay the money.

3. Maintain Detailed Records of Your Asset’s Value

Banks and loan providers are exceptionally thorough in the assessment of assets during the loan application process. They need to know that, should you default on repayments, their investment is covered by the value of your asset. This is why you need to be realistic about how much your asset is worth in the current market.

Ask an independent auditor to value your asset at the earliest opportunity. It’s a good idea to record the asset on your business’s balance sheet from day one. Your ability to keep accurate financial records will play a part in the decision-making process.

4. Assess the Risks Thoroughly

Once you have a loan offer, it’s a good idea to run it past an independent financial advisor. Understand the risks fully before you commit because you’re effectively signing over your asset to the bank until you’ve repaid the loan in full.

What will your business do if the lender takes that asset? You and your financial advisor should make a plan for the worst-case scenario. Weigh the risks against the benefits and consider alternative funding methods at the same time.

5. Don’t Be Afraid to Haggle

Banks are interested in getting themselves the best deal. Research viable alternatives before you go into any negotiation to give yourself some leverage. After all, you can always walk away and get your loan from another provider.

If you’re not happy with how the lender assessed your application, ask for a review—particularly if you believe your asset has been undervalued and you can support that belief with evidence.

Be Sure to Consider Other Options

All of these tips are vital to your chances of a successful loan application with a conventional lender—but they’re not the only considerations. After reviewing your options, you might find a traditional lending channel to be a bad fit for your needs.

Marketplace lenders, like Lendio, specialize in taking the hassle out of small business financing. Our application, for example, only takes 15 minutes, and it gets you in front of more than 75 lenders. Compare that to the 30+ hours it can take to fill out a bank application that’s only ever seen by one lender.

It’s crucial to compare your options before committing serious collateral on a loan deal. That’s just common sense. 

About the author

Andrew Mosteller
Andrew Mosteller
Andrew Mosteller is a freelance writer and regular contributor to Lendio News. His upbringing in an entrepreneurial family nurtured a passion for small business at a young age. Andrew's father, an equity fund manager, taught him the ins and outs of investment financing. Now, Andrew spends his time writing copy for business owners, helping them expand and advertise their unique brands. He's also studying Strategic Communications at the University of Utah. When Andrew's fingers aren't glued to the keyboard, he spends his time reading, podcasting, composing music, and bombing down the ski slopes.

Comments

  1. I am seeking funding for a start up. I do have collateral which is my food trailer that is fully functioning and well equipped.

    • Hi, Zach. We can help you find financing for your food truck. Check out your loan options here: https://www.lendio.com/bp/basic-info

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